Asset managers of large manufacturing enterprises, for example, computer manufacturers, electronics manufacturers and auto manufacturers, must determine the inventory levels of components and finished products that are needed to meet target end customer service levels (i.e., the fraction of customer orders that should be received by the requested delivery dates). For such manufacturing enterprises, the delivery of a finished product to an end customer typically involves a complex network of suppliers, fabrication sites, assembly locations, distribution centers and customer locations through which components and products flow. This network may be modeled as a supply chain that includes all significant entities participating in the transformation of raw materials or basic components into the finished products that ultimately are delivered to the end customer.
Manufacturing enterprises must arrange for the delivery of component parts that are needed to produce the finished products to be delivered to end customers. In general, manufacturing enterprises may purchase component parts on the market at the market rate or they may enter into forward supply contracts in which settlement takes place in the future at a currently agreed upon price or a pre-defined price mechanism such as a price indexed to other external or internal prices. In a forward supply contract, the contract details are agreed upon at the outset, but no commodities are exchanged until the settlement (delivery) date. Money is also typically not exchanged until the settlement, though the agreement may include upfront option payments or loans to the supplier. In commodity component markets, commodity suppliers typically observe large discrepancies between forecasted demand and actual demand and, therefore, are unable to accurately schedule plant capacity and reduce inventory risk. In these situations, commodity suppliers may be willing to accept lower future prices in exchange for large future purchasing commitments because these future purchasing commitments increase the proportion of forecasted demand that will be realized, reducing inventory or capacity utilization risk. Manufacturers may benefit if the future contract cost is lower than the future market price. In addition, manufacturers may also benefit from the increased price predictability provided by future supply contracts, if fixed price or price cap agreements help protect the manufacturers' margin from possible component price increases. Finally, manufacturers may benefit from the assurance of supply provided by the contract agreements that help prevent costly shortages. When assurance of supply is important and supplier flexibility is costly, manufacturers may even structure contract terms to pay upfront option payments or higher unit prices for the rights to purchase flexible quantities above and beyond the committed quantities. Uncertainties in demand, market price, or market availability, however, make valuing contract options difficult, especially when a number of contract options are considered together as a sourcing portfolio. The uncertainties also may create substantial liabilities for manufacturers when entering into future supply contracts, since demand may be less than the committed quantity, or market price may decline to less than the contract price.